How to Become an S corporation

The election to be taxed as an S corporation is made by filing Form 2553, Election by a Small Business Corporation.

Generally, within 60 days after Form 2553 is filed, the IRS will mail you a determination notice informing you that your election was either accepted or rejected. If accepted, you will also be informed as to when S corporation status will take effect.

Reminder:
Keep in mind, filing Form 2553 is merely a tax election. It does not change the legal status of the business. If your business is incorporated, the incorporation laws of the state of incorporation still apply. If your business is an LLC, the LLC laws in the state of formation still apply.

LLCs

If you formed an LLC and would like to elect S corporation tax treatment, make the election by filing Form 2553.

When to Make the Election for S corporation status

  • File Form 2553 no later than the two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year preceding the tax year it is to take effect.
  • If you file Form 2553, but miss the deadline, S status will be effective for the following year.

Example 1: You make a time election.

Your C corporation is on a calendar year (year ends December 31). You want S status to be effective for tax year 2014. File Form 2553 no later than March 15, 2014 if you want S status to take effect in 2014.

Example 2: You make an untimely election.

You want S status for 2014. You procrastinate. Form 2553 gets filed after the March 15, 2014 deadline. S status will be effective the following year, 2015.

Qualifying For S corporation Status

A corporation or other entity eligible to elect to be treated as a corporation may elect to be an S corporation only if it meets the following eight tests:

  1. The entity must be either a domestic corporation or a domestic entity eligible to elect to be treated as a corporation (i.e. an LLC), that timely files Form 2553 and meets all the other test listed below.
  2. It has no more than 100 shareholders. A husband and wife can be treated as one shareholder.
  3. Shareholders must be individuals, estates, exempt organizations described in section 401(a) or 501(c)(3), or certain trusts described in section 1361(c)(2)(A).
  4. It has no nonresident alien shareholders.
  5. It has only one class of stock (disregarding differences in voting rights). (See the pitfall involving loans just below.)
  6. It is not:any of the following: (a) a bank or thrift institution that uses the reserve method of accounting for bad debts under section 585, (b) an insurance company subject to tax under subchatper L of the Code, (c) a corporation that has elected to be treated as a possessions corporation under section 936, (d) a domestic international sales corporation (DISC) or former DISC.
  7. It has or will adopt or change to one of the following tax years: (a) a tax year ending December 31, (b) a natural business-year, (c) an ownership tax year, (d) a tax year elected under section 444, (e) a 52-53-week tax year ending with reference to a year listed above, (f) any other tax year (including a 52-53-week tax year) for which the corporation establishes a business purpose.
  8. Each shareholder consents as explained in the instruction for column K on Form 2553.

Avoid the Pitfall of Disqualifying Loans!

Large loans, for example, loans in excess of your stock basis, could be viewed by the IRS as being an investment in stock.

Since an S corporation may only have one class of stock, if the IRS deems the loan to be a second class of stock, S status may be revoked.

Straight-debt safe harbor IRC Section 1365(c)(5):

This code section says that straight-debt shall not be treated as a second class of stock.

Straight-debt defined:

Any written unconditional promise to pay on demand or on a specified date a sum certain in money if -

  • the interest rate (and interest payment dates) are not contingent on profits, the borrower's discretion, or similar factors.
  • there is no convertibility (directly or indirectly) into stock, and
  • the creditor is an individual (other than a nonresident alien, an estate, or a trust described in paragraph (2) under this subsection.

Prepare a note:

Preparing a note with normal lending terms will help in preventing the IRS from considering the loan a second class of stock.

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